Six Signs of a Winner

The month is October. The year is 1988. As the underdog Los Angeles Dodgers are shocking the Oakland A's in the World Series, Progressive Insurance is trading at $25. Adjusted for splits and dividends, that's around $0.65 per share.

Today, not long after the underdog Cardinals shocked the Tigers in the World Series, Progressive sits around $23. In other words, it's been more than a 35-bagger over the past 18 years, turning a $5,000 investment into roughly $175,000, despite a recent drop in the price. We believe there are several lessons to be drawn from the Progressive story that will help your future investing performance -- lessons that have helped our own strong performance in Motley Fool Hidden Gems. We'd like to share them with you today.

1. The power of patienceMeaningful gains do not happen overnight, of course. In late 1988, George Bush had just won the presidential election. George H.W. Bush, that is -- the current president's father. That's certainly not ancient history, but the point is that it took 18 years for Progressive to increase 40 times in value. Time and patience are two of the most important factors in investing, and they can help overcome mediocre performance, thanks to the power of compounding returns.

Consider that a person contributing $2,500 yearly to an IRA and earning an excellent average annual return of 15% will accumulate about $116,000 after 14 years. Yet someone who started investing just four years earlier will just about reach the same total by earning an average return of only 10%. The important thing is to simply get in the game as soon as you can, and then once you're in, hurry up and be patient.

2. Small is bigBack before it started its fantastic run, Progressive was valued at just $300 million -- a small cap by any measure. Today's future 60-baggers will also be small companies. They will not carry Bank of America's (NYSE: BAC) $245 billion market cap, for example. While Bank of America may very well provide solid returns over the next few years, its massive size will limit it from achieving jaw-dropping gains. Progressive itself can't even be the next Progressive, because it now sports a $17 billion market cap. Not nearly as big as Bank of America, but still too big to achieve outsized gains in the future.

Small companies offer individual investors like us many other advantages. Most institutional investors, who have billions of dollars to allocate, must avoid small caps, at least until they grow larger. That makes them underfollowed and increases the chances that they're misvalued. To see why, consider an analogy we've used before. The less activity in a marketplace or auction house, the higher the probability of pricing inefficiencies. When there is only one bidder for an autographed Michael Jordan game jersey, the chances for mispricing are infinitely higher than when thousands of investors bid every day -- every hour -- on the present price of, say, Intuit (Nasdaq: INTU) stock, which trades some 2.7 million shares each day. That inefficiency provides opportunity for us smaller investors.

3. A penny shavedProgressive was never a penny stock trading below $1 per share. Future 10- and 100-baggers are most often trading between $5 and $50 per share (at least the ones we care about). They are rarely below $5, and they certainly aren't below $1.

Penny stocks represent ultra-tiny companies whose shares can easily be manipulated by unscrupulous people misrepresenting the businesses' true potential. In short, stay away from stocks that aren't traded on one of the major U.S. markets (the New York Stock Exchange, Nasdaq, or American Stock Exchange), or that have no revenues, or that are obviously being hyped via email or discussion boards. You'll save yourself a ton of grief.

4. Dandy dividendsIn our research, we're constantly studying past big winners to find the common ties that bind them. Retailer Family Dollar Stores (NYSE: FDO) and consumer products giant Procter & Gamble (NYSE: PG) have different business models. Both, however, have trounced the market over the years, and both have paid a dividend ever since they were small companies -- in P&G's case, since 1890!

Just because a company is small and pays a dividend, though, that does not mean it is destined for greatness. But a dividend is a positive indicator, a telling sign of both financial strength and management's confidence that the company will continue to be solid through good times and bad. Progressive began paying its dividend back in 1986, when it was still capitalized at around $250 million.

5. Shareholder-friendlyIn any company we research, we believe it's extremely important that management's interests are aligned with those of the shareholders. While investors want to see their shares outperform over the years, managers who are indifferent to the stock price may be more interested in hiring friends and grabbing perks than in creating value. Tyco, Adelphia, Dynegy (NYSE: DYN) ... the list of corporate disappointments is too long to list here.

This is why we love to see strong insider ownership at a company. ColumbiaSportswear (Nasdaq: COLM) chief executive Timothy Boyle is a good example; he owns about 40% of the Hidden Gems recommendation. Peter Lewis, Progressive's chairman and founder, still owns more than 5% of the company. His stake is worth in excess of $1 billion today. If you want to talk about leadership with a vested interest in a business' long-term success, this is the perfect example.

6. Boring excitementSo a world-class company like Progressive must be headquartered in New York, right? Or Hartford, Conn., the "Insurance Capital of America"? Nope. It hails from Mayfield Village, Ohio, in the eastern suburbs of Cuyahoga County, approximately 20 miles from downtown Cleveland. Low-key. Not flashy. A bit boring, even.

Reminds us of the early days of Wal-Mart, when the company didn't raise an eyebrow among big-time analysts. Wall Street treated Sam Walton's Arkansas boys like a bunch of hillbillies, it seemed. But these sleepy, small, "boring" companies -- with no hype built into their stock price -- can offer outstanding bargains to us individual investors.

Putting it togetherIn a recent issue of Hidden Gems, analyst Bill Mann and I (Tom) both recommended small-cap insurance companies that we believe will deliver outstanding returns over the next five to 20 years. Beating the market with small-cap stocks, as we've been doing in Hidden Gems, is not as difficult as you might think. We simply start by looking at what has worked in the past, and then we go looking for it again.

Hidden Gems is now nearly three years old, and our total average return during that time is around 46%, compared with 20% for like amounts invested in the S&P 500. If you'd like to check out all of our recommendations, plus more than 20 valuable investing lessons, we're offering a 30-day free trial. Click here to give it a whirl and see the new issue that was released at noon ET today.

This article was originally published on April 8, 2005. It has been updated.

Tom Gardneris co-founder of The Motley Fool and heads up the Hidden Gems newsletter. Tom does not own shares of any company mentioned. Rex Moore is a Hidden Gems analyst and owns shares of Procter & Gamble. Bank of America is an Income Investor recommendation. Tyco, Intuit, and Wal-Mart are Inside Value recommendations. Family Dollar is a Stock Advisor recommendation. The Motley Fool isinvestors writing for investors.

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